Stocks

(The author is a Reuters Breakingviews columnist. The opinions
expressed are his own.)

By Martin Hutchinson

NEW YORK, June 22 (Reuters Breakingviews) - It’s time for
bank regulators to get heavy on risk weighting. The financial
and euro zone crises have shown the drawbacks of using banks’
home-grown models to weigh different risks. These encourage
unhealthy arbitrage by favoring assets that enjoy favorable
treatment. A tougher cap on the ratio of equity to total assets
would limit abuse. So would banning risk measures that ignore
extreme events.

New Basel III rules have lifted the amount of capital that
banks must hold. However, like their predecessors, they still
use risk weightings to calculate the asset total used when
calculating capital ratios. This has led to problems in the
past: in particular, the decision by European regulators to
attach a zero risk-weighting to sovereign debt allowed banks to
hold almost unlimited quantities of government bonds. As the
euro zone crisis has shown, government debt is far from
risk-free. Though Basel III attempts to address some of these
shortcomings, it may still underestimate sovereign risk, thereby
making corporate and consumer loans less attractive.

To combat this problem, global regulators have also
introduced a leverage ratio, which caps the total amount of
un-weighted assets that banks can hold as a proportion of
equity. But this ratio has been set at a mere 3 percent,
adjusted for derivatives, allowing banks to lever themselves 33
times. That ratio proved excessive for Bear Stearns and Lehman
Brothers in 2008. U.S. commercial bank regulators have long
imposed a ratio. Setting it at 5 percent of total assets would
make it harder for banks to load up on seemingly risk-free
loans.

But risk-weightings have another flaw: their dependence on
discredited Value-at-Risk measures, which assume that risks have
a normal distribution and little mutual correlation. The market
crash of 2007 and 2008 showed that VaR underestimates the risk
of “tail” events, encouraging traders to load up on products
that can blow up. JPMorgan’s (JPM.N) recent trading losses again
demonstrated VaR’s shortcomings.

Again, regulators are aware of the problem. In a
consultation document issued in May 2012, the Basel Committee
said banks should switch to risk management methods that
properly recognize tail risks. But for now, bank capital
measures are still too dependent on risk weightings. They should
be modified.

- The Basel III regulations' main capital requirements
involve a complex system of risk weightings for different types
of bank assets.

- From Jan. 1, 2013 to 2017, bank regulators will also test
a leverage ratio, with minimum average Tier 1 capital in each
quarter being set at 3 percent of total exposure, which is
calculated as the balance sheet total plus an additional
allowance for derivatives.

- The Basel III regulations also contemplate that banks will
calculate their risk exposure using a Value at Risk model, which
the regulators will approve.

- The Swiss National Bank has recommended that Swiss banks
should report each quarter on the risk-weighted assets
calculation performed according to the standardized risk models
used by regulators, as well as their own internal models.

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